Jeremy Grantham: Sucker's Rally Almost Over


Jeremy Grantham of Boston-based GMO called the crash.  He also called the rally.  He also called a whole bunch of stuff before that–although, as he is the first to admit, like other value folks, he does have the habit of being early.

Not this time, though.

Within days of the March low, Jeremy published “Reinvesting While Terrified,” in which he observed that it was time to bet the farm.  He soon called for a stimulus-fuelled rally that would take the S&P 500 to 1000-1100, which is where we are now.  He also laid out his expectation that the market would then move sideways for 7 years.

Well, we’ve hit the high of Jeremy’s sucker’s rally prediction.  Stocks are now once again significantly overvalued (Jeremy puts the overvaluation at 25%, with fair value on the S&P 500 at 860).  He thinks the market can go a bit higher but that it will break down next year.  He’s looking for a “painful” pullback of at least 20%.  A new low is not likely, but not out of the question.

You can download Jeremy’s quarterly letter at GMO’s site here.  It’s also embedded below.  Here’s the part on the stock market:

The Last Hurrah and Markets Being Silly Again

The idea behind my forecast six months ago was that
regardless of the fundamentals, there would be a sharp
rally [to S&P 1000-1100].   After a very large decline and a period of somewhat
blind panic, it is simply the nature of the beast.  Exhibit 1
shows my favourite example of a last hurrah after the first
leg of the 1929 crash.

After the sharp decline in the fall of 1929, the S&P 500
rallied 46% from its low in November to the rally high of
April 12, 1930.  It then, of course, fell by over 80%.  But
on April 12 it was once again overpriced; it was down
only 18% from its peak and was back to the level of June
1929.  But what a difference there was in the outlook
between June 1929 and April 1930!  In June, the economic
outlook was a candidate for the brightest in history with
effectively no unemployment, 5% productivity, and
over 16% year-over-year gain in industrial output.  By
April 1930, unemployment had doubled and industrial
production had dropped from +16% to -9% in 5 months,
which may be the world record in economic deterioration. 
Worse, in 1930 there was no extra liquidity fl owing
around and absolutely no moral hazard.  “Liquidate the
labour, liquidate the stocks, liquidate the farmers”2 was
their version.  Yet the market rose 46%.

How could it do this in the face of a world going to hell? 
My theory is that the market always displayed a belief
in a type of primitive market efficiency decades before
the academics took it up.  It is a belief that if the market
once sold much higher, it must mean something.  And
in the case of 1930, hadn’t Irving Fisher, arguably the
greatest American economist of the century, said that
the 1929 highs were completely justifi ed and that it was
the decline that was hysterical pessimism? 

Hadn’t E.L. Smith also explained in his Common Stocks as Long Term Investments (1924) – a startling precursor to Jeremy Siegel’s dangerous book Stocks for the Long Run (1994) – that stocks would always beat bonds by divine right?  And there is always someone of the “Dow 36,000” persuasion to reinforce our need to believe that as markets decline, higher prices in previous peaks must surely have meant
something, and not merely have been unjustified bubbly bursts of enthusiasm and momentum.

Today there has been so much more varied encouragement for a rally than existed in 1930.  The higher prices preceding this crash (that were far above both trend and fair value) had lasted for many years; from 1996 through 2001 and from 2003 through mid-2008.  This time, we also saw history’s greatest stimulus program, desperate bailouts, and clear promises of years of low rates.  As mentioned six months ago, in the third year of the Presidential Cycle, a tiny fraction of the current level of moral hazard and easy money has done its typically great job of driving equity markets and speculation higher. 

In total, therefore, it should be no surprise to historians that this rally has handsomely beaten 46%, and would probably have done so whether the actual economic recovery was deemed a pleasant surprise or not.  Looking at previous “last hurrahs,” it should also have been expected that any rally this time would be tilted toward risk-taking and, the more stimulus and moral hazard, the bigger the tilt.  I must say, though, that I never expected such an extreme tilt to risk-taking: it’s practically a cliff!  Never mess with the Fed, I guess.  Although, looking at the record, these dramatic short-term resuscitations do seem to breed severe problems down the road.  So, probably, we will continue to live in exciting times, which is not all bad in
our business.

Economic and Financial Fundamentals and the Stock
Market Outlook

The good news is that we have not fallen off into another
Great Depression.  With the degree of stimulus there
seemed little chance of that, and we have consistently
expected a global economic recovery by late this year
or early next year.  The operating ratio for industrial
production reached its lowest level in decades.  It should
bounce back and, if it moves up from 68 to 80 over three
to fi ve years, will provide a good kicker to that part of
the economy.  Inventories, I believe, will also recover.  In
short, the normal tendency of an economy to recover is
nearly irresistible and needs coordinated incompetence to
offset it – like the 1930 Smoot-Hawley Tariff Act, which
helped to precipitate a global trade war.  But this does not
mean that everything is fi ne longer term.  It still seems a
safe bet that seven lean years await us.

Corporate ex-financials profit margins remain above
and, if I am right about the coming seven lean
years, we will soon enough look back nostalgically at
such high profits. 

Price/earnings ratios, adjusted for even
normal margins, are also significantly above fair value
after the rally.
  Fair value on the S&P is now about 860
(fair value has declined steadily as the accounting smoke clears from the wreckage and there are still, perhaps, some smouldering embers).  This places today’s market (October
19) at almost 25% overpriced, and on a seven-year horizon
would move our normal forecast of 5.7% real down by
more than 3% a year. 

Doesn’t it seem odd that we would be measurably overpriced once again, given that we face
a seven-year future that almost everyone agrees will be
tougher than normal?  Major imbalances are unlikely to
be quick or easy to work through.  For example, we must
eventually consume less, pay down debt, and realign our
lives to being less capital-rich.  Global trade imbalances
must also readjust…

We believed from the start that this market rally and
any outperformance of risk would have very little to do
with any dividend discount model concept of value, so
it is pointless to “ooh and ah” too much at how far and
how fast it has traveled.  The lessons, if any, are that low
rates and generous liquidity are, if anything, a little more
powerful than we thought, which is a high hurdle because
we have respected their power for years.  And what we
thought were powerful and painful investment lessons
on the dangers of taking risk too casually turned out to
be less memorable than we expected.  Risk-taking has
come roaring back.  Value, it must be admitted, is seldom
a powerful force in the short term.  The Fed’s weapons
of low rates, plenty of money, and the promise of future
help if necessary seem stronger than value over a few
quarters.  And the forces of herding and momentum are
also helping to push prices up, with the market apparently
quite unrepentant of recent crimes and willing to be silly
once again.  We said in July that we would sit and wait
for the market to be silly again.  This has been a very
quick response although, as real silliness goes, I suppose
it is not really trying yet.  In soccer terminology, for
the last six months it is Voting Machine 10, Weighing
Machine nil!

Price, however, does matter eventually, and what will
stop this market (my blind guess is in the first few months
of next year) is a combination of two factors. 

First, the disappointing economic and financial data that will begin
to show the intractably long-term nature of some of our
, particularly pressure on profit margins as the
quick fix of short-term labour cuts fades away.  Second,
the slow gravitational pull of value as U.S. stocks reach
+30-35% overpricing in the face of an extended difficult

On a longer horizon of 2 to 10 years, I believe that
resource limitations will also have a negative effect (see
2Q 2009 Quarterly Letter).  I argued that increasingly
scarce resources will give us tougher times but that we
are collectively in denial.  The response to this startling
revelation, for the fi rst time since I started writing, was
nil.  It disappeared into an absolutely black hole.  No one
even bothered to say it was idiotic, which they quite often
do.  Given my thesis of a world in denial, though, I must
say it’s a delicious irony.

So, back to timing.  It is hard for me to see what will stop the
charge to risk-taking this year. 
With the near universality
of the feeling of being left behind in reinvesting, it is
nerve-wracking for us prudent investors to contemplate
the odds of the market rushing past my earlier prediction
of 1100.  It can certainly happen.

Conversely, I have some modest hopes for a collective
sensible resistance to the current Fed plot to have us all
borrow and speculate again.  I would still guess (a well-
informed guess, I hope) that before next year is out, the
market will drop painfully from current levels.  “Painfully”
is arbitrarily deemed by me to start at -15%.  My guess,
though, is that the U.S. market will drop below fair value,
which is a 22% decline (from the S&P 500 level of 1098
on October 19).

Unlike the really tough bears, though, I see no need for a
new low.  I think the history books will be happy enough
with the 666 of last February.  Of course, they would
probably be slightly happier with, say, 550.  The point
is that this is not a situation like 2005, 2006, and 2007
when for the fi rst time a great bubble – 2000 – had not yet
broken back through its trend.  I described that reversal
as a near certainty.  I love historical consistency, and with
32 bubbles completely broken, the single one outstanding
– the S&P 500 – was a source of nagging pain.  But that
was all comfortably resolved by a substantial new low for
the S&P 500 last year.  This cycle, in contrast, has already
established a perfectly respectable S&P low at 666, well
below trend, and can offi cially please itself from here.  A
new low (or not) will look compatible with history, which
makes the prediction business less easy.

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